The S&P 500 is considerably overvalued – somewhere in the range of 34% to 61% – depending on which of 4 market valuation indicators are used and whether the valuation is based on the arithmetric or geometric mean of each. While these findings are not useful as short-term signals of market direction…they play a role in framing longer-term expectations of investment returns and suggest a cautious outlook and guarded expectations. [Here are the details.] Words: 676
So says Doug Short (www.dshort.com) in excerpts from an article* which Lorimer Wilson, editor of www.munKNEE.com (It’s all about Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Short goes on to say:
The 4 market valuation indicators I follow and are used in this analysis are:
- The Crestmont Research P/E Ratio (more)
- The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
- The Q Ratio, which is the total price of the market divided by its replacement cost (more)
- The relationship of the S&P Composite to a regression trendline (more)
The chart below – which differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the “average”) – shows the range of overvaluation of the S&P 500 somewhere in the range of 40% to 61%. The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers.
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In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I’ve included the geometric variant as an interesting alternative view for the two P/Es and Q ratio.
The above indicators aren’t useful as short-term signals of market direction – periods of over and under valuation can last for years – but they can play a role in framing longer-term expectations of investment returns. At present they suggest a cautious long-term outlook and guarded expectations.
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- P/E Ratio of S&P 500 at 9 Month Low! Is It Time to Buy? https://munknee.com/2011/06/pe-ratio-of-sp-500-at-9-month-low-is-it-time-to-buy/
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- Why a Major Stock Market Correction is Imminent https://munknee.com/2011/05/why-and-how-best-to-play-a-major-stock-market-correction-is-imminent/
- S&P 500 is 45% Overvalued According to Reversion to Mean Analysis! https://munknee.com/2011/01/these-2-historical-charts-show-how-high-then-how-low-the-sp-500-might-go/
- How Mean Will the S&P 500′s Future Regression to Trend Be? https://munknee.com/2011/01/how-mean-will-the-sp-500s-future-regression-to-trend-be/
- Surprise! Limited Downside Risk Exists In S&P 500 https://munknee.com/2011/06/surprise-limited-downside-risk-exists-in-sp-500/
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.